Get it Right

January 2016

Rights issue has been an effective tool for companies to raise capital. As an investor, however, assess the company’s ﬁnancial stability before taking up your rights

A rights issue implies an offer to a company’s existing shareholders to subscribe to new shares in proportion to the current holdings. Rights issue allows listed companies to raise a working capital and a number of listed entities opt for this mode to raise capital. It is kind of a secondary market issue to raise money. This is one of the preferred modes for companies with poor cash flows which also face difficulties in going for conventional methods such as loans from banks or other financial institutions. It also comes handy when the going is not great in the equity market. However, more often than not, a rights issue tends to be more popular during a bull run in the stock markets. One of the positive aspects here is that the company does not require making an interest payment that it would have had to in case of a loan.

According to Barclays’ ‘Better Investor’, the education and insight section to help guide one’s investment decisions, those involved (in bringing out the rights issue) must take into account two conflicting factors: the price has to be cheap enough to encourage the maximum interest from existing shareholders but high enough to raise the cash the company needs.

Rights issue has been used by widely used by companies across the Gulf and globally. In December last year, Takaful Emarat, the DFM-listed Shariah-compliant life and health insurer, raised AED 50 million during the first tradable rights issue for a Takaful insurance company in the UAE. The rights issue, which was launched on 1 November and closed on 12 December was 36.51% oversubscribed with AED 68.257 Million shares fully subscribed. Early last year, leading Indian auto major Tata Motors, which also owns Jaguar and Land Rover, raised about a billion dollar through the rights issue. In December 2015, Standard Chartered raised $5 billion through a rights issue to strengthen its balance sheet. Not all rights issue however come out with flying colours.

Take the case of the $2.5 billion rights issue by Australian oil and gas producing firm Santos announced in November 2015. This was probably not the best time for an energy producer as price of crude oil has been under continuous pressure and touching new multi-year low. In spite of the sizeable discount to the market price the energy giant struggled to achieve a 100% subscription, especially from the retail investors. So, timing is also a key in addition to price of a rights issue.

According to Investopedia, troubled companies typically use rights issues to pay down debt, especially when they are unable to borrow more money. But not all companies that pursue rights offerings are shaky. Some with clean balance sheets use them to fund acquisitions and growth strategies. For reassurance that it will raise the finances, a company will usually, but not always, have its rights issue underwritten by an investment bank.

A correctly priced rights issue can turn out to be a boon for existing shareholders of a company as they get an option to increase their holding at a discount to market price. This especially makes sense for investors who believe in the long term potential of a company and have confidence of seeing good returns in the future. The subscription to rights issue allows investors to lower the average cost of their shareholding in the company. This advantage is exclusively available only to the existing shareholders. But one must expect a decline in value of existing shares owing to introduction of additional shares at a deeply discounted price.

Rights are usually renounceable. This means it gives one an option to sell one’s rights to other investors, even non-shareholders. In case of non-renounceable rights, the investor has a choice of subscribing or letting it go. If he subscribes fully to the rights, he can maintain his proportionate ownership in the expanded share base.The rights issue, if successfully subscribed, can generate additional trading interest in a company’s stock. The news of a rights issue can give a boost to the company’s stock price because new sets of investors would be willing to buy shares so that they can also participate in the rights offer on the record date in proportion to their holding.

Rights issue could be tempting because of the discount at which it gets offered. But investors must be watchful enough to check the financial stability, expansion roadmap and debt situation of the company before subscribing to the rights issue. The mode of rights issue to raise capital is at times viewed as sign of a financial stress in the company, triggered by high debt and related interest outgo. Companies usually communicate this situation to the shareholders to allow them to take an informed decision. Investors can also read about management interviews to find out about the purpose behind the rights issue and in what way it will strengthen the company’s balance sheet. Rights issue can act as a quick fix solution for the stressed balance sheet but the management must have a roadmap to eliminate the problems that led to the stress.